This is a two-parter on inflation. This month I look at the ways in which a new inflationary episode generates, and thrives upon, confusion. In Part two I’ll turn my attention to the increasingly urgent issue of counter-inflation policies.

Even now, long after the “inflation is transitory” mantra has quietly been abandoned, there remains a great deal of confusion about the current inflation. Here are some of the confusions I run into every day:

One is the claim that “the current inflation is the result of supply bottlenecks. Accordingly, once these bottlenecks are cleared up, inflation will go away.”

It isn’t, and it won’t. Of course, any policy that lubricates the supply chain is to be welcomed, but it won’t cure inflation.

Another confusion is the idea that “inflation is simply the result of corporate greed.” It isn’t. This is an age-old confusion; a way of thinking that leads to dangerously counterproductive policies such as price controls. Price controls make things worse.

Finally, for now at least, the idea that “inflation is caused by excessive wage demands.” It isn’t. This is another age-old confusion that tends to lead to incomes policies. Incomes policies, just like price controls, make things worse.

However, in fairness I should point out that it’s in the very nature of inflation to throw sand in the eyes of the beholder. Confusion is the lifeblood of inflation.

In ordinary times, the principal method of information transmission in the economy – the way we discover what’s what – is the price system. One of the great mischiefs of inflation is the way it hopelessly distorts the price system. As we shall see, it doesn’t just add white noise into the system, it actually inverts its signals.

Now, the economy is confusing enough without inflation. Although each of us must navigate it every day, the economy is a strange terrain. Unlike other terrains, which are wholly indifferent to our choices, the economy changes in response to the routes we choose. Worse, it changes in ways we simply cannot predict.

This is why the economy is in a permanent state of flux; formed anew at each instant by the countless decisions of apparently unconnected actors. Because of that, as Keynes put it: “we have, as a rule, only the vaguest idea of any but the most direct consequences of our acts.”

In other words, we necessarily live with radical uncertainty: we don’t really have much of a clue about the long-term, or even the medium-term consequences of our decisions. In fact, let’s face it, even the immediate consequences of our actions often take us by surprise.

The best we can do is to take note of the information – the price signals – we encounter and then process them via tried and tested rules of thumb, “heuristics”, to make our decisions.

Where do these rules of thumb come from? We gradually pick them up from our parents, teachers, friends, colleagues, and, of course, from our own experience. Interestingly, a common theme in folk tales and proverbs is how to make decisions in the face of uncertainty: a stitch in time saves nine; a bird in the hand is worth two in the bush; better safe than sorry, etc. Heuristics survive in a Darwinian manner: we stick with the ones that have worked in the past.

Radical uncertainty, by the way, is inescapable. It is built into the fabric of the economy. Keynes’ example: “What will the price of copper be in twenty years from now?” is indicative. You can look at the past performance of copper prices, at plans to open or close copper mines, historic shifts in the demand for copper, etc, and from that build a probability distribution from which to make your forecast.

Unfortunately, it will be a complete waste of time. Uncertainty isn’t risk – there isn’t a well-defined range of possible outcomes. There’s no way to predict innovations that might transform the copper market in twenty years. It’s a principle that can be applied generally.

But what does it all have to do with our starting point: the confusions endemic in inflation?

Well, as I said, the economy is a confusing, ever-changing place and we rely on rules of thumb to process the signals. However, when inflation strikes, the meaning of the signals changes. We don’t realise this at first, and go on as before, using our tried and tested methods. That’s why, in the early stages of inflation, everyone from the members of the Bank of England’s Monetary Policy Committee to the self-employed handyman tends to do the wrong thing.

When, as novices, we arrive in a new inflationary period, we automatically assume that, for example, a pay rise means we are better off; or that if we sell an item for more than we paid for it, we must be in profit; and that an increase in our sales means our product must be becoming relatively more popular.

Inflation can give the lie to all these apparent truisms. It’s as if for years we’ve been happily making our outdoor plans using the heuristic: “Red sky at night, shepherd’s delight; red sky in the morning, shepherd’s warning.” But before we realise it, everything changes.

Suddenly, the evening sky turns red when rain is on its way. What happens? We go ahead with our picnic and get soaked! Conversely, the sky’s red in the morning when it’s going to be a scorcher. Once again, off we go, wrongly dressed in our raincoats, carrying umbrellas. We lug unnecessary items around town all day, as we swelter.
This is a precise analogue of what happens as we enter a new inflationary period: our epistemic mechanisms, the methods we use to understand the world around us, stop working. Nothing seems to make sense.

It’s altogether unsurprising that this can lead to feelings of resentment. We naturally look for someone, or something, to blame. Here lies a primary root of the appalling political damage that inflation inflicts.

Inflation is a global issue, and the longer it’s left to grow, the greater the damage it’s going to cause. What can be done? Find out in Part two next month.

Peter Lawlor is a trustee of the John Hicks Foundation in Oxford. He was formerly the Principal Economic Advisor to the German Stock Exchange (Deutsche Börse), and continues to act as an adviser to senior Wall St figures and political leaders. These are his own views and should not be imputed to any organisations with which he is, or has been, affiliated

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